Do You Understand Your Credit Score?

Talk about credit scores seems to be everywhere - it's on the 10 o'clock news, your credit card company keeps asking you to sign up for credit monitoring, and a young man with shaggy hair and a guitar is always popping up on your TV whining about driving a used subcompact. (For related reading, also take a look at 8 Slipups That Won't Hurt Your Credit Score.)

Yet, consumer research conducted by the Consumer Federation of America and VantageScore Solutions shows that many Americans don't really understand their credit scores. Even if you think the hype about credit scores is overrated, you should at least understand the basics - it can save you thousands of dollars.

The Purpose of a Credit ScoreAccording to the Consumer Federation of America, the primary purpose of a credit score is to help lenders assess individuals' risk of not repaying a loan. It is not to assess borrowers' knowledge of consumer credit, their attitude toward consumer credit, their amount of consumer debt or the financial resources they have to repay a loan.

Factors that Affect Your Credit ScoreYour credit score is essentially based on five things:

1. Payment HistoryDo you pay your bills on time? If not, how late are you, and how often are you late?

2. Amounts OwedHow much total credit do you have available, and what percentage of it are you using?

3. Length of Credit HistoryWhen did you first start using credit, and what is the average age of all your credit and loan accounts?

4. New CreditHow much credit have you applied for and taken on recently?

Factors That Don't Affect Your Credit ScoreSome people think that their credit score factors in their age, marital status, gender, race, nationality or state of residence, but none of these are included in your score. Most of this information doesn't even appear on your report and is prohibited from being used for credit considerations under the Equal Credit Opportunity Act.

Who Checks Your Credit and WhyYou probably know that anyone you want to borrow money from is going to check your credit - this includes mortgage lenders, credit card issuers and car dealerships. Creditors use your credit score to determine whether to lend you money and if so, what interest rate you will get. The higher your credit score, the lower the interest rate you will qualify for, and the less you will pay to borrow that money. It follows, of course, that the lower your credit score, the more interest you will pay, if you can even get a loan or a credit card at all.

But did you know that home insurers, landlords, cell phone companies and electric utilities may also use your credit score? It can be used to determine whether you can get insurance and at what cost, whether to rent you a living space and at what price and whether to require a deposit when you establish cell phone or utility service.

Your Credit Score is Really Three ScoresThere are three major credit bureaus - Experian, Equifax and Transunion - and each one calculates your score somewhat differently, giving you three somewhat different credit scores. Ideally, you'd like each of those scores to be at least 720 - this is the score that will usually qualify you for the best interest rates in today's market.

Learn More about Credit ScoringYou are entitled to one free copy of your report every 12 months from each of the three credit bureaus (the easiest way to get it is through www.annualcreditreport.com). Looking at your credit report will help you understand what is on your report and what isn't. It will also allow you to check for any mistakes that could be harming your credit score and check for any signs of possible identity theft (like accounts you don't recognize).

The free credit report does not include your credit score, but unless you're planning on making a major purchase that requires credit (like a mortgage or a new car) in the next six months, or you're having trouble getting approved for a credit card, you don't particularly need to know your score. If you do want or need to know your score, you'll have the option to purchase it while you're obtaining your free report. (For addition information, see How To Dispute Errors On Your Credit Report.)

You may be able to obtain your score for free by signing up for a credit monitoring service the offers a free trial (though it won't be free if you forget to cancel before the end of the trial period) or by applying for a loan and obtaining your score from the lender. If you don't need to know your actual score and just want to get a general idea, there are websites that will help you estimate it.

The Bottom LineNo matter how much those credit score commercials might irritate you, their underlying message is sound: understanding the basics of credit scoring is essential to managing your finances well. Without that understanding, you could end up wasting money on high interest rates or miss out on achieving goals like home ownership.